No. 0.751 is correct and I explain why in the lecture (and is explained in the printed answer). Using the dividend valuation formula for years 4 to infinity gives a PV in 3 years time, so this needs then to be discounted for 3 years.

In Q1 of 2020, the flows are from year 5 onwards (not year 4) and the answer is then discounted for 4 years.

Hi Sir, as we know the formula for computing the cost of equity under the CAPM method is: Ke = Rf + Equity beta * (E(rm) – Rf).

However, in practicing other questions, particularly valuation questions, I notice that in the answers, the Rf rate is not deducted from the E(rm) as required in the formula. Do you have an idea why this is so?

It depends whether the question tells you the market return or the market premium. When you are given the market premium then this is the return on the market less the risk free rate. (So if the risk free rate is 5% and the market return is 15%, then the market premium is 10%)

The free cash flow is the cash available for all lenders (i.e. equity and debt).

However when we are asked for the free cash flow to equity (as in example 4) then we are after the cash available just for the equity and then we will subtract anything going to debt.

Hi John, not sure if this is the correct place to ask this. If we have a cash flow which increases in perpetuity like in the above example, how would we account for tax on this cash flow? Would it be the same as years 1 to 3 by simply taking the cash flow and deducting tax? Thanks in advance.

It depends on the timing of the tax. If tax is payable without any delay then yes – you would take use the cash flow less tax. However if (as is more likely) there is a one year delay in the tax, then you need to calculate the PV of the cash flow before tax, then get the PV of the tax flows by multiplying the PV of the before-tax cash flows by the tax rate and discounting this figure for one year.

(It is OK asking here except that I don’t always see comments here. So better is to ask in the Ask the Tutor Forum – I always see questions posted there and so always answer 🙂 )

What is the reason for not deducting interest in Example 2. Earning are given before interest and tax, so we have to deduct tax and add back depreciation. Please explain

Free cash flow is before interest (just as we ignore interest in Paper FM (was F9) when appraising projects. We discount at the WACC (which takes account of the cost of debt) to get the value of the business.

The free cash flow to equity is after interest, and is discounted at the cost of equity to get the value of equity.

Multiplying by 1/r give the PV at time 0 of a perpetuity starting at time 1.

Since the prepetuity starts 3 years late (at time 4 instead of time 1) multiplying by 1/r gives a PV 3 years late – at time 3 instead of time 0. So we need to discount for 3 years.

For the FCF formula, Is the amount needed to replace non-current asset considered as capital expenditure? If yes, does that mean we separate total capex investment into 2 part, one is to replace current depreciated fixed asset (of which equal to depreciation), and the other part is to invest additional fixed asset?

aniruddhborkar says

splendid explaination

moheikal says

Hi sir,

I think, DCF for year 4, should be discounted by 0.683 instead of 0.751 as per Q1 March 2020,.

John Moffat says

No. 0.751 is correct and I explain why in the lecture (and is explained in the printed answer). Using the dividend valuation formula for years 4 to infinity gives a PV in 3 years time, so this needs then to be discounted for 3 years.

In Q1 of 2020, the flows are from year 5 onwards (not year 4) and the answer is then discounted for 4 years.

nicole321 says

Hi Sir, as we know the formula for computing the cost of equity under the CAPM method is: Ke = Rf + Equity beta * (E(rm) – Rf).

However, in practicing other questions, particularly valuation questions, I notice that in the answers, the Rf rate is not deducted from the E(rm) as required in the formula. Do you have an idea why this is so?

John Moffat says

It depends whether the question tells you the market return or the market premium. When you are given the market premium then this is the return on the market less the risk free rate. (So if the risk free rate is 5% and the market return is 15%, then the market premium is 10%)

nicole321 says

Thank you sir! This has been very helpful.

John Moffat says

You are welcome 🙂

salvia cardoso says

Hi John,

Thank you for the very clear lesson.

I have a question… why isn’t the loans repaid included in the equation.

John Moffat says

You will have to say which equation / question you are referring to 🙂

vaniapuddoo says

Hi John. In example 2, there is a loan repaid of 48. Any particular reason why we do not account for that?

John Moffat says

The free cash flow is the cash available for all lenders (i.e. equity and debt).

However when we are asked for the free cash flow to equity (as in example 4) then we are after the cash available just for the equity and then we will subtract anything going to debt.

Liam says

Hi John, not sure if this is the correct place to ask this. If we have a cash flow which increases in perpetuity like in the above example, how would we account for tax on this cash flow? Would it be the same as years 1 to 3 by simply taking the cash flow and deducting tax? Thanks in advance.

John Moffat says

It depends on the timing of the tax. If tax is payable without any delay then yes – you would take use the cash flow less tax.

However if (as is more likely) there is a one year delay in the tax, then you need to calculate the PV of the cash flow before tax, then get the PV of the tax flows by multiplying the PV of the before-tax cash flows by the tax rate and discounting this figure for one year.

(It is OK asking here except that I don’t always see comments here. So better is to ask in the Ask the Tutor Forum – I always see questions posted there and so always answer 🙂 )

Liam says

Hi John, thanks very much for the speedy reply. This has made it a lot clearer for me.

John Moffat says

You are welcome 🙂

sidishah says

Sir in eg 2 the free cash flow of $228is the total value of the firm right and not the market value of the equity.

John Moffat says

No – that is just the cash flow for the year.

The PV of the free cash flows will be the value of the firm (equity + debt) 🙂

PranavMV says

What is the reason for not deducting interest in Example 2. Earning are given before interest and tax, so we have to deduct tax and add back depreciation. Please explain

John Moffat says

The after-tax interest is accounted for in the calculate of the WACC.

Just as when appraising projects we never include interest in the cash flows for the same reason.

salvia cardoso says

Hi John, why isn’t loans repaid deducted?

John Moffat says

It is when calculating the free cash flow to equity, but not when calculating the free cash flow to the firm.

Elena says

Hello. Please tell about the example 2: why don’t we subtract the interest paid to get the free cash flow?

John Moffat says

Free cash flow is before interest (just as we ignore interest in Paper FM (was F9) when appraising projects. We discount at the WACC (which takes account of the cost of debt) to get the value of the business.

The free cash flow to equity is after interest, and is discounted at the cost of equity to get the value of equity.

I do explain all of this in the free lectures.

changha says

hi john why don’t we discount for four years because the qstn is saying from 4 yrs to infinity

John Moffat says

Multiplying by 1/r give the PV at time 0 of a perpetuity starting at time 1.

Since the prepetuity starts 3 years late (at time 4 instead of time 1) multiplying by 1/r gives a PV 3 years late – at time 3 instead of time 0.

So we need to discount for 3 years.

herafatima says

Hi John, the values are not given for example 2; free cash flows; in the lecture notes. can you please reply back with the question.

Regards,

John Moffat says

Download the notes again – they were re-uploaded a few weeks ago.

herafatima says

Thanks 🙂

duybachhpvn says

Hi John,

For the FCF formula, Is the amount needed to replace non-current asset considered as capital expenditure? If yes, does that mean we separate total capex investment into 2 part, one is to replace current depreciated fixed asset (of which equal to depreciation), and the other part is to invest additional fixed asset?

Thank you

John Moffat says

Correct (although you don’t really need to show the split – just don’t add back the depreciation, but do subtract any additional investment).